Oil & Gas Part I – Where Are the Opportunities?

This article is intended to be part of an ongoing series. My objectives for the series include:

Sharing my investment philosophy and thought process,

Mapping out sectors and industries I am targeting,

Analysing the best opportunities in each industry.

I believe studying the greatest investors in the world improves my chances of enjoying success with my investments. My research of the “SuperInvestors” has led to a long-term investment approach that attempts to identify companies / stocks that:

Are understandable,

Have growth opportunities,

Are financially healthy,

Are highly profitable,

Are predictable,

Are well managed,

Have limited downside, and

Are cheap.

Within the above criteria, I feel that the most critical consideration is the price paid and that price is the most important driver in achieving high returns. A focus on price, combined with a contrarian approach, often leads me to the cheapest sectors and industries where I hope to find hidden gems possessing the other seven characteristics I’ve listed. At the time of this writing, the sector with the lowest Shiller P/E is the energy sector, with a value of 14.8 versus 25.1 for the S&P 500.

Having established that there could be attractive opportunities in the energy sector, the next question I ask is whether such opportunities are understandable to me. Fortunately, the energy sector is where I have worked my entire career, providing confidence in my level of comprehension. If my search led to a sector where I had less knowledge, I would venture on in hopes that I could quickly build a level of understanding; however, the moment I realized I was not interested in the subject manner or incapable of acquiring the knowledge in a reasonable time frame, I would move on. Since I’ve established an attractively priced sector and the requisite understanding, the next question is whether that sector has favourable long term prospects; it is here that I will begin my discussion of the energy sector.

To determine whether growth prospects exist for energy, let’s take a step back and look at the drivers for demand:

World population: At its core, energy demand is driven by the number of people. The world population passed the 7 billion mark in 2011. Current projections of population growth suggest the world population will continue to grow until at least 2050 (see graph below):

Increasing wealth in emerging markets: When economies grow, their energy needs grow. Consumers want cars, air conditioners, refrigerators, and other energy hogs. China and India will lead this.

Globalization: As we move more often, further, and with greater speed, the energy we use in transportation will inevitably increase. Air travel in particular is a heavy user of fuel.

Concerns over securing energy supply: Long-term concerns over energy security around the world have led to higher premiums paid for energy assets.

To provide a baseline for future energy demand, we can start by looking at current consumption levels. Based on BP’s Statistical Review of World Energy from June 2013, fossil fuels dominate current energy consumption (84%):

Energy Source

Consumption (MM toe)

% of Consumption

Oil

4.0

32%

Coal

3.5

28%

Natural Gas

3.0

24%

Hydroelectricity

0.9

7%

Nuclear

0.7

6%

Renewables

0.3

2%

Total

12.4

100%

Review of numerous studies paints the following picture of future energy demand:

Joint study by U.S. Department of Energy (DOE) and EIA: Technology will advance, but fossil fuels will continue to dominate (see graph below):

Among the fossil fuels, oil demand should remain strong into the future with > 60% used in transportation, and the emerging world playing catch up with respect to vehicles. The future for natural gas also looks bright due to its abundance, cleanliness (relative to oil, nuclear & coal), advantages in power generation (lower power plant Capex), potential for gas to liquids conversion and growth potential in transportation.

Having identified particularly favourable growth prospects for oil and gas related companies, a quick analysis of the U.S. Oil & Gas (O&G) sector results in the following:

U.S. O&G Sector

Count

+ve EPS

% w/ +ve EPS

Median ROE%

Median ROC%

Meidan P/E

Median EV/EBIT

Median EV/EBITDA

Drilling

83

35

42%

9.4

10.0

11.0

11.6

6.6

Exploration & Production

393

162

41%

8.6

6.6

17.0

15.9

7.2

Equipment & Services

137

100

73%

11.2

15.8

15.5

14.1

8.9

Integrated

60

45

75%

13.2

13.5

11.3

7.5

4.9

Midstream

60

43

72%

9.1

7.1

27.9

23.8

14.5

Refining

54

38

70%

9.6

10.7

11.3

11.2

6.8

Total

787

423

54%

9.6

9.7

15.6

14.1

7.8

*Profitability & Valuation Metrics only taken for companies with +ve EPS.

The main takeaways from the above table include:

Equipment & services and integrated oil & gas companies appear to be the most profitable.

To explain these two takeaways and identify the most compelling opportunities, further industry analyses are needed. In the next article in the series, I plan to map out the Drilling industry. I will include what type of drilling environments have the best long-term prospects and which companies are best positioned to take advantage of those prospects.

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